China’s soaring debt threatens growth and investment

Opinion: Countries that borrow and spend excessively pay a high price

SatyajitDas

SYDNEY (MarketWatch) — Economists seem to have only recently identified China’s debt problems. In fact, the country has had a 35-year addiction to cheap credit that now threatens to stunt its growth.

New lending by Chinese banks has been equivalent to around 30% or more of GDP. Around 90% of this lending has funded investment in building, plant, machinery and infrastructure, especially by State Owned Enterprises. According to the World Bank, almost all of China’s growth since 2008 has come from “government influenced expenditure.”

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China’s official estimates are far more conservative. According to a 2013 report from China’s National Audit Office, Chinese government debt, including local government debt, is around 55% of GDP (around $5 trillion), an increase of around 60% from 2010.

The National Audit Office argues that this figure includes around $1.6 trillion of contingencies (debts of government-owned financing vehicles) of which the government in the worst case would only have to cover a small portion (say 20%). This would reduce the actual public debt to around 39% of GDP.

But Chinese government debt figures may not be complete, as it may exclude debts from local governments and central departments outside the Finance Ministry. It may also exclude debt of large state-owned enterprises, state-owned policy banks and special purpose asset-management companies that hold nonperforming loans purchased from state-owned commercial banks, which all trade on the basis of an explicit or implicit government support.

If these items are included, then China’s government debt, including contingent liabilities, would be higher, perhaps 90% of GDP.

There has been a parallel increase in private sector debt. Business and household debt levels have reached around 150%-170% of GDP, a large increase from around 100%-115% in 2008. Corporate debt has increased sharply, approaching 150% of GDP. Traditionally considered compulsive savers, Chinese households have increased borrowing levels from around 20%-30% to 40%-50% of GDP.

Ceilings and limits

That said, China’s debt is lower than developed economies, allowing government officials to claim that it is at a “safe level.” But if all debt is included then the country’s overall debt is high, especially against comparable emerging markets. Many Asian emerging markets had lower debt and higher per-capita GDP prior to the Asian monetary crisis of 1997.

Corporate debt levels are above developed countries (averaging around 90% of GDP) and well-above firms in other emerging markets (less than 100% in Brazil, around 80% in India and 60% in Russia).

The rate of increase in China’s debt is also concerning. Several economies — Japan in the late 1980s, South Korea in the 1990s, the U.S. and U.K. in the early 2000s — experienced such rapid growth in credit, resulting in serious financial crises. China has experienced a similar expansion in debt. Such consistent above-trend increases in borrowing levels have historically provided an early warning of problems.

Another measure is the credit gap — the difference between increases in private-sector credit growth and economic output. Research studies have found that 33 countries with credit gaps experienced a subsequent rapid slowdown in growth, typically by at least 50%. In China, the credit gap since 2008 is above 70% of GDP.

Chinese credit intensity (the amount of debt needed to create additional economic activity) has increased. China now needs around $3-$5 of debt to generate $1 of additional economic growth, although some economists put this even higher at $6-$8. This is an increase from the $1-$2 needed for each dollar of growth a decade ago.

Newman Communications via Bloomberg

Satyajit Das

In China, debt increasingly to funds purchases of existing assets, which does not add directly to economic activity. Investment in new physical assets has fallen to about 70% of investment on already existing assets including land; a significant change from 2008 when these two measures were roughly equal.

Debt be not proud

China has benefitted from a large expansion in residential construction, but now faces a property glut. Official data estimates that unfinished housing stock is equivalent in value to more than 20% of GDP. The most infamous is the “ghost city” of the Kangbashi district of Ordos in Inner Mongolia, which at one stage had apartments to shelter a million people, about four times its current population. Another example of excessive spending is the city of Tiajin, which has invested more than $160 billion in an effort to create a financial center — a price tag almost three times the cost of China’s Three Gorges Dam, one of China’s most expensive projects.

The increased level of debt and the often uneconomic projects financed has led to increasing concern as to whether the debt can be serviced.

A 2012 Bank of International Settlements research paper on national debt servicing ratios found that a measure above 20%-25% frequently indicated heightened risk of a financial crisis. Using the BIS, analysts have estimated that China’s debt-service ratio may be around 30% of GDP (around 11% goes to interest payments and the rest to repaying principal), which is dangerously high. Moreover, a large portion of this debt is secured by land and property, whose values are dependent of the continued supply of credit and strong economic growth.

A substantial portion of the debt may be short term, with around 50% of loans being for one year. But as few Chinese borrowers have sufficient operating cash-flow to repay loans, around one-third of the new debt is used to repay or extend the maturity of existing debt. When significant amounts of new debt is needed to merely repay existing debt, the amount of borrowing constantly increases to maintain economic growth.

The concern is that debt-fueled investment has created economic growth but in the medium- to long-term will result in rising bad debts and financial problems.

Economist Hyman Minsky identified three phases of finance during periods of prosperity, with financial structures become progressively more risky. Hedge financing is where income flows can meet principal and interest on debt used as finance. Speculative financing is where income flows cover interest payments but not principal, requiring debt to be continually refinanced. Ponzi finance is where income flows cover neither principal nor interest repayments, with the borrower relying on increasing asset values to service debt.

China observers now worry about whether high absolute levels of debt, rapid increases in borrowing, increasing credit intensity, servicing problems, and the quality or value of underlying collateral are likely to result in a financial and economic crisis — a Minsky Moment.

Satyajit Das is a former banker and author of “Extreme Money” and “Traders, Guns & Money.”

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